Seven Things Everyone Should Know About Annuities
Annuities come in a wide variety of flavors. The myriad combinations of annuity payout structures, benefits, death benefits, and other contractual elements make it difficult to state definitively if annuities are the right investment for you.
In a previous article, we covered things to be aware of regarding annuity death benefits, especially the inadvertent tax burden an annuity might carry for beneficiaries. But in this article, we will look at seven important risks to the annuitant—the person taking out an annuity.
1. Say “No” to Sales Pressure
Investigations by FINRA—the Financial Industry Regulatory Authority—discovered that some variable annuity marketing practices were unethical, especially when aimed at seniors. Complex language and endless combinations of options and “riders”—conditions or provisos added to a contract—can make annuities incredibly confusing.
Sometimes, variable annuity marketing strategies even use scare tactics, informing customers that variable annuities are a way to prevent their assets from being seized.
It is vital for investors to do their own research regarding annuities so they can understand all the options that exist for them. Investors should also ensure they are dealing with a broker in good standing. This can be done by checking the broker’s background via FINRA’s BrokerCheck service.
2. Expenses are Often Hidden in Annuity Contracts
One of the more crippling aspects of annuities is their complicated fees. These include “surrender charges” should you want to take some or all of your money out early.
Early withdrawals by an investor who has not yet reached the age of 59 ½ will usually incur a 10 percent tax penalty. And, because annuities are tax-deferred, any gains will be taxed as regular income.
Instead of a simple, flat fee, many annuities charge “layers” of fees, which can sometimes add up to thousands of dollars a year.
Riders also add fees, and yet many riders are necessary to reduce the risk for the annuitant.
It’s important to remember that annuities are insurance products, not investments, per se. And insurance companies have to hedge against risk. They do this by charging many fees across many thousands of clients.
Per FINRA rules, financial professionals are obligated to make these fees known in an unambiguous manner. And you have a right to complain to FINRA if you feel your broker is not doing so.
3. Annuities May not Protect you from Inflation
The average inflation rate since 1913 is 3.22 percent. At that rate, something that costs $10 today will cost $18.85 in twenty years. That’s almost 100% inflation!
And averages don’t always tell the full picture. There can be spikes in inflation as happened in the 70s where inflation hit an average of over 7 percent as a result of bad Federal Bank policies.
Inflation is a major concern for retirees, and it’s important to know that annuity income is not adjusted for inflation. There might be other investments that are better suited to hedge against inflation.
4. An Annuity May be Unsuitable for You
You may not need an annuity. Social security and other investments might be enough to carry you over in your retirement years, making an annuity unnecessary. And extremely wealthy people are also unlikely to need an annuity. Artists who receive regular royalty payments might likewise not need an annuity.
5. “Guarantees” Are Only as Good as the Insurance Company
Many variable annuities come with guarantees issued by the insurance company. But if the insurance company’s financial strength is not up to par, those guarantees won’t be worth the paper they’re written on. And the Federal Deposit Insurance Corporation (FDIC) does not insure annuities as it does for bank accounts, so if the insurance company goes bust, so does your annuity.
Credit rating agencies such as AM Best and Standard & Poor’s can provide information about a company’s financial strength, and more information about those companies can be found on the SEC website. Investors should do their due diligence using these tools before deciding on a company to take out an annuity with.
6. Annuity Are Highly Complex
Few investments are as complicated as annuities. Not only do the endless combinations of choices make it difficult to understand them, but the use of industry nomenclature puts them out of the grasp of most people. Even attorneys, CPAs and other professionals who regularly review annuity contract often misinterpret aspects of the products.
7. Do You Understand “Floors” and “Caps”
Indexed annuities—annuity contracts that pay out interest based on an underlying market index such as the S&P 500—typically have “floors” and “caps” which set limits on losses and gains for the annuitant. This is to protect both the annuitant and the insurance company.
The floor sets a minimum amount of return that the investor can expect. And a cap sets a maximum limit.
Although these limits might not seem important when viewed over the short term, the differences in earnings can be staggering when compared to investing directly in the underlying index in the long term. In some cases, annuities with floors and caps might even perform worse than standard Treasury Bonds over a decade.
Much of this depends on the details of that particular annuity, but it’s important to remember that, once you’ve signed the annuity contract, you are locked in, and withdrawing early or diversifying the money into other investments is impossible without penalties.
Annuities are insurance products more than they are investments. And insurance companies have to eke out a little from a lot of people to hedge against losses.
Annuities can be quite confusing, and they are incredibly restrictive.
On the other hand, they also require little maintenance and might be a good option for anyone not interested in actively managing an investment portfolio themselves. The most important thing is that investors must do their due diligence in any annuity they consider taking out, and that includes checking out the firm and broker